All you wanted to know about the US fiscal cliff

The Budget Control Act of 2011 codified in law a grudging political compromise forcing the government to slash spending by $1.2 trillion over 10 years from 1 January 2013. Photo: Hemant Mishra/Mint

Washington: The “fiscal cliff” is a combination of dramatic spending cuts and tax increases mandated to take effect beginning in January if US President Barack Obama and Republicans cannot bridge their differences on how best to reduce the nation’s budget deficit and debt.

To add to a drama that could reverse the slow US recovery and impact the global economy, the US is also about to reach its borrowing limit, so Congress will also be asked to raise the government’s debt ceiling.

What is the fiscal cliff?

The Budget Control Act of 2011 codified in law a grudging political compromise forcing the government to slash spending by $1.2 trillion over 10 years from 1 January 2013.

Next year’s cuts, called “sequestration,” would be about $109 billion.

Also on that date, a package of tax reductions and an extension of unemployment benefits will expire, meaning taxes will rise significantly for most Americans.

Why will this happen?

Democrats and Republicans have long been deadlocked over whether to address a $1 trillion-plus annual budget gap with higher taxes or lower spending.

The Budget Control Act was a poison-pill deal designed to force them to find a less austere compromise, but political wrangling and dysfunction meant no deal was done, and the deadline is now looming.

What happens if the cliff is not avoided?

Together, higher taxes and lowered spending could slice the $1.1 trillion deficit racked up in fiscal 2012 (ended September 30) by almost $500 billion next year, according to the Congressional Budget Office (CBO), vastly improving the government’s financial picture.

But CBO estimates the shock treatment would send the country back to recession and push the unemployment rate to 9.1%.

Deep cuts would come to both defence and non-defence spending. Government suppliers and contractors would lose business, and temporary furloughs could be in store for tens of thousands of federal employees.

Taxes and automatic paycheck deductions would increase for most Americans, reducing the cash they have for spending, and taxes on capital gains and dividends would rise, hitting investors.

What is the debt ceiling?

The US government will hit its statutory $16.39 trillion debt limit on Monday, according to treasury secretary Timothy Geithner.

The limit is set by Congress, and if it is not raised, the US will not be able to borrow any more money and would, in theory, be forced to slash spending to make ends meet.

Possible, but desperate, remedies would include halting pay to the military, retirement health benefits, social security, and failing to pay government debts.

Will the US default on its debt?

Not immediately. The treasury has various extraordinary measures in its armory, including halting the issuance of securities to state and local governments, which could buy about two months of leeway.

What would a default mean?

No one is sure: the dollar, and treasury bonds, are the primary currency of global finance, and holders do not really have any alternatives. And most believe that eventually the US government would make good on its debts. However, the country’s credit rating could be further downgraded, likely pushing up its borrowing costs over the medium term and possibly diminishing the dollar’s cachet in world finance.

What will Congress do?

Eventually, the Congress is likely to raise the debt ceiling but Republicans who run the House of Representatives will use the showdown as leverage to demand spending cuts from Obama in return. It is uncertain how high the raised borrowing limit will be, and any resolution will likely trigger a new confrontation between Obama and Republicans the next time around.